Key Points:

• Falling oil and natural gas prices are causing brokerage analysts to reevaluate their forecasts on E&P companies
• During the past two weeks, earnings estimates have been cut on 41 E&P companies
• Positive revisions still outnumber negative revisions by a large margin, but the trend is clearly turning negative

Since early July, crude prices have dropped by more than 20%. Natural gas prices have dropped even more. Fears of weakening demand helped to deflate the energy bubble.

The demand concerns have been caused by revised forecasts for the energy sector and slower economic growth worldwide. Yesterday, the International Energy Agency proclaimed an easing to the tight global and supply balance that had played a significant factor in driving oil prices higher. Today, Japan said that GDP fell 0.6% last quarter.

For investors holding onto oil stocks, especially exploration and production (E&P) companies, this creates a problem. As I have previously stated on our Zacks Elite web site, brokerage analysts are likely using crude price targets of $110 to $120 per barrel in their profit forecasts.

Estimate Revisions

Starting last year, as the oil bubble inflated, brokerage analysts were forced to constantly adjust their models to reflect higher crude prices. This resulted in numerous positive revisions on oil exploration and production (E&P) companies. As long as oil remained above the prices used in the profit models, it was logical to believe that more positive revisions would occur.

Now the situation is reversing, with oil headed below what many analysts have factored into their models. Therefore, it is now logical to assume that profit forecasts will be lowered.

Profit Forecasts Starting to Get Cut

The numbers suggest a trend towards lowering profit projections has started. During the past two weeks, 81 full-year earnings estimates have been cut on E&P companies.

Andarko Petroleum (APC) has received the most negative estimate revisions with 7 covering brokerage analysts cutting forecasts. Though APC exceeded second-quarter earnings expectations with profits of $1.76 per share, its revenues were a bit light.

Forest Oil (FST) follows closely behind with 6 negative estimate revisions. Again, better-than-expected second-quarter earnings have not stopped brokerage analysts from lowering their full-year profit projections.

Denbury Resources (DNR), EOG Resources (EOG), Quicksilver (KWK) and XTO Energy (XTO) all have had five brokerage analysts cut their profit projections in the last two weeks. Earnings forecasts have also been cut on 35 other E&P companies.

Some Disagreement Does Exist, But The Trend Is Negative

As negative as this seems, the aggregate trend in estimate revisions for this industry group remains overwhelmingly bullish. The revisions ratio is 1.67, reflecting 214 positive revisions and 129 negative revisions. (Within recent weeks, 6 brokerage analysts have raised their full-year forecasts on APC and 3 have increased their profit projections on FST.)

The problem is with the trend, however. When oil prices peaked last month, the revisions ratio for E&P companies stood at 17.2, reflecting 241 positive revisions and 14 negative revisions.

Oil could fall to between $80 and $100 per barrel, barring any supply disruptions. Were this to happen, more earnings estimates could be trimmed on E&P companies.

This is not a case of anything being inherently wrong with the fundamental strength of these companies, but rather a change in the short-term risk/reward ratio. We have reduced our exposure to the energy sector in the Zacks Elite Focus List portfolio with the intent of adding back some oil and natural gas companies at lower prices.

For those wanting exposure to the oil and natural gas sectors, integrated oil and oil machinery and equipment stocks might be safer over the short-term. (We hold ConocoPhillips (COP) and National Oilwell Varco (NOV) in our Focus List and Top 10 portfolios, respectively.) Those unwilling to endure short-term volatility may want to consider waiting for oil and natural gas prices to settle, however.

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Charles Rotblut, CFA, is the senior market analyst for Zacks.com. He can be reached at crotblut@zacks.com.